Investment prices rise and fall, sometimes by significant
amounts at a stretch. A sustained increase in prices is called a
bull market. A sustained drop of 10% to 20% is called a correction;
a sustained drop of more than 20%, a bear market. All three
conditions are facts of market life.
In the stock market, periods of sustained increase and periods
of sustained decline have tended to alternate over time. What's
more, as a general rule, the periods of increase have tended to
outweigh the periods of decline. As a result, equities generally
appear to have had the strongest average performance of any
investment class over the long run, although past performance is no
guarantee of future results.1
If it were merely a matter of arithmetic, it could be relatively
simple for an investor to wait out a market dip for the next
recovery. But how investors feel about their portfolios can be just
as important. Price dips tend to stoke investors' fears. So, when
stock prices begin falling, many investors tend to act quickly and
make poor decisions, adversely affecting their financial
On the other hand, investors who have taken steps to prepare
their portfolios for occasional market drops generally are better
able to manage their emotions when stock prices head south. They
could make thoughtful changes but only where there would be solid
rationales to support them.
Sizing Up Your Portfolio
While the best portfolio design anticipates all possibilities
from the outset, you can improve your planning at any time. So, if
confronted with an unanticipated market condition, take time to
review your portfolio. Are all your investments in stocks or stock
mutual funds? Do you own just one stock mutual fund? Have you
invested in only a few high-flying stocks?
Remember, all investments involve risk. As a long-term investor,
you should not focus on short-term volatility. But you can also
make the long journey a little more enjoyable by taking a few steps
during a market correction. Here's a short list of some risks you
may face as a holder of stocks or stock mutual funds and some ideas
about how to potentially reduce the chances that your portfolio
suffers a big loss.
- Overly narrow asset allocation. You can reduce
market risk attributable to stocks by allocating part of your
portfolio to other assets, such as bonds or bond mutual funds and
Treasury bills or money market funds.2 When stock prices
decline, it's possible that a rise in your bond or money market
investment will help cushion the fall. Keep in mind that investment
in a money market fund is neither insured nor guaranteed by the
U.S. government, and there can be no guarantee that the fund will
maintain a stable $1 share price. The fund's yield will vary.
- Underdiversification. If you own only a couple
of stocks, you are extremely vulnerable if one suffers a big
decline. Experts recommend that stock investors hold several stocks
in different industries. That way, if one stock falls sharply, the
drop will have a limited influence on your portfolio.
Underdiversification is also a risk with mutual funds, a risk you
may temper by holding a few stock mutual funds with different
investment objectives. Diversification does not protect an investor
from potential loss.
- Downside risk. A stock that drops 50% in value
can have a devastating impact on a portfolio. The next stock you
own would have to climb 100% to offset that initial decline. You
can potentially reduce downside risk by focusing on less volatile
stocks. Also consider looking for issues that pay solid dividends.
Mutual fund investors should look for funds that invest in similar
types of stocks.
- Volatility. Someone who is investing for the
long term should not be too concerned if the investment bounces
around from one day to the next. What is important is that the
investment continues to perform up to expectations. You can cut
volatility risk by investing the money you may need in the next
five years in a more conservative investment. You may want to be
more aggressive with the money you earmarked for use in 15 to 20
- Liquidity risk. When a particular investment
is said to have a liquid market, it typically means that you can
readily buy or sell a position at or near the most recent
previously reported selling price. On the other hand, investments
that are illiquid may not have a ready buyer for positions you want
to sell or a ready seller for positions you might want to buy. In
those cases, you might be forced to accept a steep premium or
discount from the most recent previous price in order to execute a
trade. The size of the deviation is one measure of liquidity risk;
another is the potential delay between ordering a trade and
executing it. The brokers' term for trades in investments with the
lowest levels of liquidity is "trades by appointment only."
A Healthy Market Decline
It's important to remember that periods of falling prices are a
natural and healthy part of investing in the stock market.
Investors who are concerned about this risk can consider strategies
to help them limit their overall investment risk position.
One risk that some investors may be exposed to is the risk of
falling short of reaching a long-term financial goal. Investing too
conservatively may contribute to not reaching an accumulation
target. Remember that despite several down cycles, stock prices
have historically risen over longer time periods. (Past
performance, however, does not guarantee future results.)